Gold Prepares For Assault On March 2008 Highs

09/17/09 08:28:03 AM

by Donald W. Pendergast, Jr.

It's taken a full 19 months, but gold appears to be on the verge of exceeding the all-time highs made in March 2008.

Security: Gold, GC, GLD
Position: Accumulate

Gold. Some people hate it and say it's the worst long-term investment in the world. Others love it for its ability to protect purchasing power during periods of monetary inflation. Some traders buy it at exactly the wrong time, after an already overheated move higher, even as frustrated investors sell it just before it bottoms and turns higher. Be it as it may, what is the current state of gold and is there a way to profit from it in the here and now?

FIGURE 1: GOLD, MONTHLY. Breakouts can be tricky, but the underlying momentum in monthly gold appears to favor further upside in this unique commodity.

Graphic provided by: MetaStock.

Figure 1 is the Handy & Harmon monthly base price of gold, plotted back to late 2004. Note how consistent the recent action of the Aroon (14) indicator is over the past five years or so; every time the Aroon (14) closed above the 70 level (top blue horizontal line on its indicator window), gold went on to achieve substantial gains over the next three to eight months. The Aroon has just performed that technical feat again, right at a time when cash gold is just $15 from its all-time high and a significant chart pattern breakout is already under way. In addition, the relative strength index (RSI)(14) is maintaining a very bullish posture, with a reading now approaching 63.00. Check out the rising wedge pattern on the RSI (14); compare any breakout here with any further breakout follow-through on the gold price chart for further confirmation of this developing trend move. Finally, note the wide spread between the 20-period (red line) and 50-period (blue line) exponential moving averages (EMAs); even after the sharp correction in gold last year, these two EMAs are now suggesting that this is one commodity uptrend that is solidly back in the black.

Now, the tough part -- how to play this move, just in case the breakout fails to carry through as expected or, even worse, starts another major leg down. As always, we can count on the option market to come to the rescue with an interesting idea or two. Here's the plan -- consider building a gold short strangle, but do it one step at a time in order to take advantage of the current upthrust in the yellow metal of kings. Here's how:

1) Sell 1 February 2010 Comex Gold $750 put option for $2 or better. Use a limit order and be patient -- a market order may net you a worse fill than expected.

2) Wait to see how gold handles the March 2008 high; in other words, wait for some strong follow-through -- well beyond that price -- to something over $1,150 or even $1,200 an ounce. At that point, premiums on out-of-the-money gold call options should be highly inflated. Consider selling a February 2010 Comex Gold $2000 call option, particularly when the weekly indicators are beginning to show some signs of weakening. You may be able to sell such a call for $3 to $4 during the next four to six weeks, knowing that gold would have to rise by $800 to $850 by late January 2010 (February gold futures options expiration) in order for it to expire in-the-money.

If you are able to sell both the put and the call in this manner, you'll likely collect a total of $500 to $600 in option premiums (before commissions). And if you wait to sell the February $2,000 gold call on further gold strength, the February $750 put will likely have withered away to next to nothing as gold rises in price. You could buy it back before expiration and book an early profit, or you may just decide to enjoy the ride and let it run until expiration. Meanwhile, the $2,000 gold call option will have a very small delta value, meaning that it will be unlikely to go in-the-money by February options expiration. Time decay will eat away at the option (both the put and the call) value every day, really accelerating during the final 30 days prior to expiration. And if gold rallies and then corrects hard after you sell the $2,000 call, you may even wish to buy it back early, ensuring a profit without having to wait for expiration.

While this trade isn't suitable for most traders, for those who trade futures, it may be worth a look. The open interest on the Feb 2010 $750 put is about 1,219 contracts, while the Feb 2010 $2,000 call comes in at around 919 contracts. This should be more than adequate to enable a decent fill on both entry and a possible early buyback.

Bottom line: For those who are bullish on gold through January 2010 (but not too bullish), selling a 750/2000 gold futures option strangle could be a no-nonsense way to profit from gold as it makes the time transition from one decade to another.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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Gold Prepares For Assault On March 2008 Highs

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